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Wall Street's Worst-Kept Secret

Psst! Hey buddy, want some personal investment advice?

Investors who make the most money over the long term invest in common stocks – not bonds, not gold, not even real estate.

At least, they have since Ibbotson Associates started keeping tabs in 1926. Investors who make even more invest in small-company stocks, also according to Ibbotson. That's not personal investment advice -- that's Wall Street's worst-kept secret.

The way I see it, there are few ways we can play this right now. We can roll the dice on a small-cap mutual fund, if we can find a good one accepting new money. We can buy a small-cap exchange-traded fund (ETF) – I've owned a few myself for years. Or we can start building a small-cap portfolio of our own.

You're a Fool ... and so am INaturally, we favor the do-it-yourself approach. Well, sort of. You see, I recently had the pleasure of discussing the subject with Motley Fool co-founder Tom Gardner -- a guy who made a career out of digging up well-run small companies ahead of Wall Street.

I'm beginning to suspect that Tom is onto something, and that the team of analysts he hand-assembled to run his Motley Fool Hidden Gems small-cap advisory service is building a portfolio of small companies I probably couldn't have found on my own – including more than a dozen that have doubled in value or more.

How do they do it? I think it's that, when digging up well-run small companies, these guys focus on fundamentals, while I tend to get wowed by story. Moreover, they have a checklist of important criteria they measure their potential targets against, including:

Solid management with significant ownership stakes.

Great, sustainable businesses.

Dominant positions in important niche markets.

Sterling balance sheets.

Strong free cash flow.

I know it's hard to imagine now, but many of these same traits gave investors the courage to follow a young man named Howard Schultz into Starbucks(NASDAQ:SBUX), a longtime Motley Fool favorite. The same goes for Sam Walton and Wal-Mart back in the 1970s. Both were incredibly profitable investments for many years.

Good work if you can get itI know what you're thinking: Who wouldn't want to own names like Starbucks and Wal-Mart -- at least in their prime earning years? And you're right. That's why it's so hard to beat the pros with familiar stocks like those when they're hot; if they're really all that, they're going to cost you.

But what are you going to do? Take a chance on some fly by-night outfit? Good point. But notice we've been talking about well-known stocks -- not necessarily well-known companies. Of course, there's a difference.

Take a flashy tech outfit with a sexy name like Level 3 Communications(NASDAQ:LVLT) or Tellabs(NASDAQ:TLAB). These were familiar tickers long before many traders figured out what they actually do. Companies like BJ Wholesale Club(NYSE:BJ), on the other hand, have strong regional or even national footprints long before they hit Wall Street's radar.

Need more proof?Check out my buddy Tim Hanson's list of the best-performing stocks of the past 10 years. But don't expect to find a bunch of story stocks like Sirius XM Radio(NASDAQ:SIRI) or Suntech Power(NYSE:STP). In fact, I'm willing to bet you haven't heard of more than one from your broker, though you might recognize a bunch from "real life" -- Green Mountain Coffee Roasters(NASDAQ:GMCR), for example.

And that's your edge: You can always find established, profitable companies with unknown stocks. Some you've heard of; some you may not have. Peter Lynch was a master at digging up these gems. That's precisely how he earned his Fidelity Magellan (FMAGX) shareholders nearly 30% year after year.

Of course, beating the market with a mutual fund is a crapshoot. That's why I'm a fan of exchange-traded funds (ETFs) -- you get broad exposure to the entire group without the management fees associated with typical funds. I've done well with both the iShares S&P 600 Small-Cap Growth Index (IJT) and the value index.

Some more personal adviceConsider testing the waters with a low-cost fund like iShares S&P 600 Small-Cap Value Index (IJS) and then shift gradually into the stocks that Tom Gardner's guys tell you about each month in his Hidden Gems newsletter. Sooner or later, you want to be exposed to at least a few small businesses with big potential.

Even better, if you're curious how Wall Street's worst-kept secret can help you beat the pros, think about this: Look into accepting a no-risk free trial to the complete Hidden Gems service. That way, you can look on for free as the team builds a real money portfolio of small-cap stocks.

You can even print out every back issue and check out all the recommendations, if you like. Best of all, the first month is on me, and there's never any pressure to subscribe. I haven't seen a market better suited to small caps since 2003. I bought then, and I'm buying now. I hope you'll join me. To learn more about trying Hidden Gems for free, simply click here.

This article was originally published on Jan. 7, 2005. It has been updated.

Paul Elliottowns shares of the iShares S&P 600 Growth Index and the iShares S&P 600 Value Index, but no other securities mentioned in this article. You can see all the Hidden Gemsrecommendations you're yourfree trial. Starbucks is aMotley Fool Stock Advisor pick. Wal-Mart and Starbucks are Inside Value picks. Suntech Power and Green Mountain Coffee Roasters are Rule Breakers choices. The Fool owns shares of Starbucks and has a fulldisclosure policy.